Magazine Article | May 13, 2012

Insights Into Your Capital Structure

Source: Life Science Leader

By Christopher Geier

Access to appropriately and affordably priced capital is often the lifeblood of any company.  The search for that capital — whether through bank loans, private funding, research grants, equity investment, or other sources — while a daunting exercise, is a must for growing companies.

The good news for life sciences companies is that this industry is considered a healthy, growing sector, and there are numerous capital options — both in terms of equity and debt — available for companies that demonstrate sound business fundamentals.   The trick is in understanding what potential capital resources you are looking for in order to improve your chances of securing appropriate capital with optimum terms and in the time frame you want or need.

Fundamental to any quest for capital is your ability as a company owner or leader to guide your company to achieve and maintain an optimum capital structure — that ideal combination of equity and debt. That combination will be different for every organization, but it always means balancing your desire for financial returns with your stakeholders’ appetite for risk.

The Basics
In the simplest form, an organization’s capital structure is its combination of debt and equity. This combination is clearly reflected on the balance sheet, one of the very first things a capital provider will want to see. Depending on the company, if it  is in need of raising any type of capital, either equity or debt, investors and lenders alike prefer, and often require, a strong balance sheet complete with an appropriate composition of equity and debt. The reason? A strong balance sheet reflecting a healthy equity/debt ratio is an indication of a company with good fundamentals.

Equity
In general, a company’s equity consists of:

  • common stock
  • preferred stock
  • retained earnings.

A healthy amount of existing equity capital is a strong indication of a company’s financial fitness. Investors and lenders are both biased toward a meaningful level of equity relative to debt.  You can build equity in your company by retaining additional earnings rather than deploying them or by additional paid-in-capital.

Equity Funding Options
The life-stage and existing financial health of your organization will largely dictate the options you have in attracting equity capital. Start-ups, early-stage companies, and those in need of growth capital are almost always forced to approach equity investors. Equity investors, such as venture capital or private equity firms, will supply an infusion of capital in return for a partial ownership interest in the company.  The cost of the investment is directly related to the expected return on that equity, adjusted for risk. In other words, the higher the risk, the higher the need for return to those investors; ergo the “risk-reward proposition.”  And, because early-stage and start-up companies are inherently more risky propositions, equity will likely be quite expensive. By expensive, I mean the investor will require a larger ownership interest.

One of the more common examples of equity investing is securing partial ownership in a company through the purchase of common stock or, more often, preferred stock. Preferred stock typically bears a coupon, or interest rate, and is convertible into common stock at the holder’s discretion. Although common and preferred stock are technically unsecured capital, they are theoretically and practically the most valuable capital in a company’s capital structure because they represent the company’s ownership.

So what exactly do equity investors look for in making investments? That is an excellent question, and the answer is surprisingly consistent around the world. Equity investing is about finding those companies that either have high-growth potential or demonstrate healthy business fundamentals:

  • strong management with skin in the game
  • solid industry characteristics of significant scale with room for growth
  • a defendable competitive advantage
  • a sales channel without customer concentration.

Remember, an equity investor generally does not want to run a company, but rather invest in one that will return a multiple on the investment. So, the more you can demonstrate sound business practices and show demonstrable results — generally through a well-thought-out business plan and execution — the more options you will have. 

Debit And Credit Lines — The Debit Side Of The Equation
In exploring the lending environment for your capital needs, there are three essential questions:

  • Can you borrow the money that you need?
  • How much will you pay for that funding?
  • When should you borrow or explore refinancing options?

There are numerous traditional debt structures, which include: 

  • senior term loans — in which a company’s assets serve as the collateral for a loan
  • revolving lines of credit — credit which fluctuates up and down as it is used
  • subdebt or mezzanine debt — often a hybrid of debt and equity financing.

There are alternative structures that are interesting options for businesses that aren’t quite a fit for a traditional structure. An example might be a company that has good cash flow but has little in the way of assets. Alternative structures include: 

  • unitranche (debt that combines both senior and subordinated debt into one debt instrument with one interest rate, which is a blended rate between senior rates and subordinated rates)
  • second-lien term debt
  • club-term sub debt
  • rate-only sub debt
  • high-yield private debt.

What drives the differences in these structures? The answer can be found in your company’s balance sheet and cash flows. There are many things bankers look at as they evaluate the creditworthiness of your company, but chief among them are:

  • assets — your assets are the collateral for the debt.  Assets are generally physical things such as  your brick-and-mortar, equipment, or inventory.
  • cash flow — The cash flow is what will be required in order to make the debt payments or “service the debt.”

How does that translate into how much you can borrow? Banks like to look at something called total leverage, which is defined as total debt to your earnings before interest, taxes, depreciation, and amortization (EBITDA).

Part of this total leverage concept is most certainly senior debt, that which is fully secured by assets of the company, and quite possibly a piece of mezzanine or subordinated debt.  Currently, senior debt to EBITDA is approximately 2.3x for middle market companies, and subordinated debt to EBITDA is approximately 1.0x, for a total debt to EBITDA ratio of approximately 3.3x. Simply put, if your company is doing $10 million in EBITDA, assuming you had sufficient collateral, you could likely borrow approximately $33 million.

What drives the need for a more alternative structure? Lack of collateral and cash flow — the challenge of many early-stage or start-up entities. Those two things alone will drive not only the amount of money your company is capable of borrowing, but your cost of borrowing. In the relationship between risk and reward, lenders will require a higher reward as the amount of risk they are taking increases. There are significant differences in cost to be sure. How significant? Typically secured debt is priced at 150 to 400 basis points over LIBOR (London Interbank Offered Rate), unsecured debt at 14% to 19%.  

If you are wondering how banks charge you the rates they do, let me shed some light. Macroeconomic variables drive changes in the short-term interest rate, which in turn also affect longer-term rates. For instance, when the Federal Reserve raises the federal funds rate in response to high inflation, expectations of future inflation, and/or improved economic activity, longer-term rates will adjust upward accordingly. Why? Because investors, capable of receiving greater rates of return with capital invested in short-term maturities, will now require an even greater return for investments in longer-term maturities, risk-adjusted for time.

If that seems complicated to you, you’re not alone. Everyone, including policymakers, economists, and businesspeople would like to better understand how a change in short-term rates will affect longer-term rates, largely because the latter rate determines borrowing costs for businesses and consumers alike, which in turn helps to determine aggregate demand in the economy.

The takeaway? Typically lower interest rates mean lower borrowing costs. The right time to refinance existing debt is when you can secure lower rates and associated fees than what you currently have. In addition, lower rates also may provide you with the flexibility to recapitalize your balance sheet or, more simply, to borrow money at a lower rate to change your company’s capital structure in some way.

As an example, which we’ve also seen in the life sciences industry, one of our recent clients found itself in a situation where the owners were required to pay back their early-stage equity investors with principal plus interest. More frequently than you might think, companies in this situation are often forced to sell their companies to pay back those early equity holders. In essence, the price or cost of the equity needed to start and grow a company may very well require the sale of the company. In our client’s case, this happened at a time when debt was affordable, which allowed the company’s principals to borrow the capital needed to pay off their investors at a very reasonable interest rate.   

So at this point you may be wondering:  Is there an optimal capital structure; the perfect mix of equity and debt? The simple answer is no. For those sagacious management teams, the use of leverage increases the amount of financial resources they have available to them. The notion that management is good enough at deploying capital to create greater returns on that borrowed capital than the cost of those funds is well accepted and generally practiced. Oh, but there is a problem with too much debt or being what is affectionately referred to as “overlevered,” a condition we don’t have near enough time to talk about here. Simply put, smart money usually always favors higher levels of equity and lower levels of debt.


About The Author
Chris Geier, a 20-year veteran in the capital investment and investment banking field, is CEO of Sikich Corporate Finance LLC. Over the course of his career, Geier has provided financial advisory and mergers and acquisitions services to public and private companies across disparate industries.